Big Business Is Taking Over California’s Marijuana Industry

Is a big business takeover inevitable for the legal cannabis industry?

The legal cannabis industry is budding in North America. Yeah, it may sound cliche, but there’s really no better way to describe the rapid growth in legal weed sales. According to cannabis research firm ArcView, legal pot revenue grew by 33% in 2017 to $9.7 billion in North America, and it’s expected to near $25 billion by 2021, representing a compound annual growth rate of a scorching 28%.

Where’s this growth coming from? First of all, Canada legalized medical marijuana back in 2001 and now stands on the verge of allowing adults to purchase recreational weed, legally. Waving the proverbial green flag on adult-use marijuana is a $5 billion bump to the legal weed industry in Canada. To our south, Mexico legalized medical cannabis in June of 2017. And domestically, 29 states have passed broad-based medical pot laws since 1996, with nine states giving the OK for recreational weed use.

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Of course, the U.S. is a really unique case. Unlike Canada and Mexico, marijuana firmly remains an illicit substance at the federal level. As a Schedule I drug, as defined by the Controlled Substances Act, it’s deemed as being wholly illegal, highly prone to abuse, and has no recognized medical benefits. In fact, it’s on par with LSD and heroin, based on its current classification. This makes state-level legalizations somewhat precarious, and is why most investors have chosen to put their money behind Canadian pot stocks rather than U.S.-based weed businesses.

But regardless of marijuana’s legality, one constant remains throughout North America: Big business wants its share.

Big business is leaving its mark on the legal weed industry

While most cannabis enthusiasts would probably prefer to see small businesses thrive, it’s big business that’s been making its mark on the space.

In our neighbor to the north, eight growers could wind up controlling somewhere in the neighborhood of 70%, or more, of aggregate annual production by 2020 or 2021. The top three growers — Aurora Cannabis(NASDAQOTH:ACBFF), Canopy Growth Corp., and Aphria — are expected to top 1.3 million kilograms of cannabis per year, combined, with the top eight perhaps producing around 1.8 million kilograms annually, altogether.

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Furthermore, these Canadian growers have greatly expanded their capacity through consolidation. Aurora Cannabis is in the process of buying Ontario-based MedReleaf for $2.5 billion in an all-share deal, and it recently closed the buyout of Saskatchewan-based CanniMed Therapeutics. Meanwhile, Aphria acquired Nuuvera, which greatly expanded its international reach.

In many ways, the consolidation of growing capacity in the hands of just a few growers in Canada is what has the potential to make the industry so successful. Economies of scale are what will allow Aurora Cannabis, Canopy Growth, and Aphria, to keep their per-gram growing costs well below market prices for pot, even if the price were to nosedive in the years that lie ahead.

Big business sets its sights on California

Now, big business is beginning to turn its attention to the California, the fifth-largest economy in the world.

For those of you who may not recall, Californians voted decisively in November 2016 (57% in favor to 43% opposed) to approve Prop. 64 and make adult-use marijuana legal. Dispensaries officially opened their doors to the public on Jan. 1, 2018, kicking off what could become an industry with more than $6 billion in annual sales just from recreational weed. Of course, $6 billion is a big number, and it’s more than tempting to lure in deep-pocketed big businesses that want a taste of this rapid growth.

According to a recently published analysis from Marijuana Business Daily, licensing data in California showed that 20% of cultivation licenses (that’s 697 total licenses) in the state belonged to just 12 licensees. Put in a different context, just 0.7% of the aggregate cultivation businesses within the state controls a fifth of the production.

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This push by big business into the cannabis space is liable to leave a mixed impression on consumers and investors. At the beginning, big businesses with deep pockets may flood the market with cannabis, regardless of demand, for two reasons. One, they want to get their product in front of as many consumers as possible, with the intention of engaging the consumer and hopefully creating brand loyalty.

Second, and far more important, these big businesses with deep pockets aim to drive down the price of cannabis on a per-gram basis. In doing so, margins will take a noticeable hit. Smaller businesses simply don’t have the capital to survive a significant decline in per-gram marijuana prices. By driving smaller businesses out of the market, or gobbling them up, bigger business will have more clout in terms of product pricing down the road.

Ergo, in the beginning this is going to be a consumers’ market, and not necessarily represent the best environment for investors. Marijuana prices on a wholesale and retail basis could fall, precipitously, for a few years. Thereafter, though, the remaining big businesses should have much stronger pricing power and be able to take advantage of their economies of scale. Perhaps three to five years down the road, it’ll turn into an investor’s market but be potentially bad news for the consumer.

This has happened before

And if you think this won’t happen in California, think again, because it’s happened before.

According to FiveThirtyEight.com, the exact same scenario has played out in Washington state, where wholesale and retail cannabis prices have plunged since the summer of 2014, when sales commenced. Whereas wholesalers could get up to $8 per gram back when sales first began, TopShelfData.com shows that wholesale cannabis is going for about $2.53 per gram in the state, as of September 2017.

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Why’d these pot prices decline so quickly? Look no further than big business, which not only found ways to bulk up capacity, but also introduced state-of-the-art technology that made growing marijuana significantly cheaper. These economies of scale allowed these bigger businesses to thrive in Washington, even as wholesale cannabis prices fell.

Washington state has also witnessed its fair share of consolidation. Through September 2017, the 10 largest cultivators in the state harvested 16.79% of all dry-weight cannabis, which is more than the 500 smallest farms combined, which produced 13.12% of all dry-weight cannabis. Though Washington state does cap the size of grow farms at 90,000 square feet, up from an original maximum farm size of 30,000 square feet, there is no cap on the number of cultivation licenses a business could have, providing a red carpet for bigger companies to control production.

Additionally, alternatives forms of marijuana are becoming increasingly popular in Washington state — and that’s a side of the market traditionally dominated by big businesses. Whereas dried cannabis accounted for 94.8% of total sales back when retail sales kicked off in the summer of 2014, they accounted for just 54.5% of total sales as of September 2017. With oils, extracts, and edibles growing in favor among the public, big businesses are pushing these higher-margin alternative products.

The table is set for big business to make its mark on the North American legal weed industry, whether you’re ready for it or not.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.